One of the more interesting sectors I learned about as a Hedge Fund Analyst was the Rare Earth Metals industry. Your average Joe (or Wong in Asia) on the street probably has no idea what these things are but they are basically a handful of minerals used (in very small quantities) in the production of hybrid car batteries, mobile phones, ipods, and several other high tech devices. You might remember seeing them on the Periodic Table in your high school Chemistry class. Recall those elements grouped at the bottom?

Contrary to what their name implies, Rare Earth Metals are actually not very rare but because the mining and purification process is quite dirty and labor intensive, most production that existed in the West slowly moved to China during the 90’s and 00’s which now controls 95-97% of the market. Aside from lower costs and lax environmental regulations, the migration of production was also helped along by Deng Xiao Ping and the Chinese government in the 1980’s. As the Economist recently put it, they believed Rare Earth Metals could become to China what oil was to the Middle East. And alas, their forward looking vision seems to have come true.

I first learned about the sector 5 years ago when I met the management of China Rare Earths. This USD $180m company had about 80% of the market in China and even back then, China Rare Earth told me that the government was actively limiting the opening of new mines in an attempt to restrict supply. Of course this was a wonderful thing for China Rare Earth as it solidified their position in the market as a practical 壟斷 (monopoly). The problem with investing in China Rare Earth was that the company’s size made liquidity a big problem. Additionally, as with many natural resource companies in China, pricing and asset valuations (how much reserves did they really have) were not particularly transparent. The company also had a tendency of growing non-operating expenses faster than revenue (how many cars and female consorts does management need?).

Rare Earth minerals never made much news here in the United States until a public assessment by the US Military (Rare Earth’s clearly have military applications) pointed out that China’s dominance had the potential to become a National Security issue should exports be restricted. One article discussing this topic can be found here. The discussion and subsequent hearings/bureaucratic posturing then adjurned to study the feasibility of re-starting US based production which effectively shut down 10 years ago due to safety concerns (and China’s lower priced competition). Then, like clockwork, a seemingly unrelated altercation between China & Japan over a territorial dispute brought the whole Rare Earth supply issue front and center when shipments to Japan were apparently halted. Although China denied any such embargo existed, press reports piled up and stock prices of Rare Earth companies soared. Take a look at China Rare Earth:

Pretty amazing huh? While Japanese electronics manufacturers smartly stockpile Rare Earth metals, most analysts believe current inventories will be depleted within 4-5 months without fresh deliveries. Around the same time things between Japan and China were heating up, a Colorado based company named Molycorp (which is one of the only US based Rare Earth producers and previously ran the California mine mentioned above) opportunistically went through an IPO and has since more than doubled in price. Adding more fuel to the fire were reports earlier this week that China had expanded its embargo to the US only adds more fuel to the fire.

While producers of Rare Earth metals outside of China do exist, they are running at or near full capacity and new production at Molycorp’s California mine would likely take at least a year to come on line. Similarly, as more and more electric cars, ipods, and mobile phones being sold every day, the situation seems destine to get worse before it gets better.

One the other hand, China’s supply restrictions (whether true or not) have clearly rattled both markets and more importantly, foreign governments. While Beijing clearly has a stranglehold on these essential technological ingredients, they may well have overplayed their hand by ensuring new supplies from Eastern Europe and the United States eventually come online putting an early end to Deng’s reality.